Wednesday, March 4, 2009

The Fed Goes for Brokerage

By PETER EAVIS
If you missed the first hedge-fund boom, now may be the time to put up your shingle. Looking at the terms of the Federal Reserve's new Term Asset-Backed Securities Loan Facility, investors using it should be able to generate hefty returns with little risk.
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Ben Bernanke testifies on Tuesday before the Senate Budget Committee
The TALF effectively turns the Fed into a generous prime brokerage. The central bank lends money for up to three years to investment firms to buy bonds backed by assets like auto or credit-card loans.
The Fed needs to lure investors back into the market for these asset-backed securities, or ABS, where new issuance has almost disappeared This has led to a contraction in lending to consumers, deepening the recession. In the fourth quarter of 2008, there wasn't any issuance of U.S. credit-card ABS, compared with $23 billion a year before, according to Dealogic.
Buyers have disappeared partly because they can no longer borrow the big sums once used to juice returns on ABS purchases.
The TALF ladles out that leverage, and it may well work in kick-starting the moribund market. For instance, investors can borrow $92 million to buy $100 million of bonds backed with prime auto loans. An investment firm would have levered its equity over 12 times, which could provide annual returns of over 20% on prime-auto ABS assuming no credit impairments.
What's more, the Fed, unlike a bank, won't demand the investor post collateral if the ABS market value falls over the three-year life of the loan.
What could go wrong? There is the risk of political outcry if investors reap massive gains. From a macroeconomic perspective, the TALF could distort the consumer deleveraging necessary for a lasting economic recovery.
Specific to the TALF itself, much depends on getting the pricing right. Hedge funds may want sweet returns, but issuers are going to want to issue at the lowest-possible interest rate. And since plenty issuers can borrow cheaply elsewhere right now, some can hold out and keep loans on their own books.
Lenders also may balk at the fact they can only issue triple-A-rated securities to TALF-funded buyers, meaning they have to retain lower-rated, riskier slices of the bond. That is good because lenders are likely to be more careful when making the loan it will then package up. But it could also hamper their appetite to issue large amounts of securitized product.
Perhaps the biggest risk is that TALF sucks liquidity away from other important segments of the debt markets, like longer-term corporate bonds. The Fed could get round this by broadening the TALF to include more types of assets. But that sucks it ever further into supporting credit markets.
The best outcome is that the TALF acts as a spark to rekindle the broader securitization market. But if credit markets remain sickly, the Fed faces the uncomfortable prospect of being "prime broker" to a huge investor base for years to come.
Write to Peter Eavis at peter.eavis@wsj.com